Mary is a waitress who, when tips are included, earns $15 per hour. Mary chooses to work 40 hours per week. Assume there are no taxes, so Mary earns $600 per week. A slowdown in the restaurant's business cuts Mary's hourly wage in half, to $7.50 per hour. To compensate Mary for the lost income, Mary's rich parents begin sending a gift of $300 per week.

Question

(i) Design an indifference curve-budget line diagram illustrating this situation.
(ii) Does Mary now choose to work more or fewer hours? Does Mary's consumption rise, fall, or remain unchanged? Is Mary now better off or worse off?

Answer 1

(i) If Mary chooses to work 40 hours per week, total earning will continue to equal $600 per week ($300 per week in wages plus the $300 per week gift). Thus Mary's new budget line passes through the initial optimum as shown below.



(ii) Mary chooses to work fewer hours, because the lower relative wage creates a substitution effect. Mary will now earn less than $300 in labor income, so Mary's consumption will fall. Mary is better off because the gift is large enough to place the new optimum on a higher indifference curve.